Investing for Retirement: A Personal Odyssey

For most of us in full time employment, the major source of pension income will be derived from one’s Employer’s Pension Fund. Together with some additional investments in one’s personal capacity this would previously have been sufficient to derive an adequate pension. This assumption is no longer valid for a number of reasons.

The genesis of this disconnect was the introduction of Defined Contribution Pension Funds some 20 years ago. Previously most employees contributed to what was known as a Defined Benefit Pension Fund. In terms of this arrangement, the retiree would be paid a pension calculated on the basis of 2% per every year employed times by the average salary over one’s last x years of employment. For most employees, this would equate to approximately 70% of their final salary. Combined with their private savings, this would ensure a pension of at least 80 to 90%, a fairly comfortable retirement without having to agonise over one’s financial situation.

Approximately 20 years ago, the concept of the Defined Contribution PensionFund was introduced to salaried employee. Supposedly this innovation would allow the employee control over their own retirement funds. Moreover, due to their flexibility, they were supposedly able to generate a far larger return than their staid predecessor. The final clincher was the flexibility of this form of pension. With visions of a vacation filled retirement, most employees were enticed & somewhat beguiled in the knowledge that they were financially secure.

Accompanied by a slick “roadshow” showcasing these positives, all employees were subtly coerced to switch from Defined Benefit to Defined Contribution model. What was not stated was the overriding reason for this change in philosophy and the potential downside especially with less sophisticated employees. Instead of receiving a guaranteed 70% after 35 years employment, the employee would be left to the vagaries of the market and the Asset Managers & Advisors and their fees.

With 10 years of retirees as evidence, what has been the net result? Has the average employee been financially advantaged or not?

Admittedly my observations are unscientific, relying solely on anecdotal evidence but the general trend does not appear to be favourable. From the admittedly tiny sample size, the pension disbursement is on average of the order of 50% of one’s final salary. Coupled with the fact that the payouts from their personal Retirement Annuities were far below their expectations has resulted in many retirees, if not being in penury, at least having to make a substantial lifestyle adjustment – DOWNWARDS.

Probably one of the shortcomings of this approach was when the Employer allowed an Employee to select a lower deduction percentage at their discretion. In one case, a friend did select a lower percentage when they changed jobs at a lower salary. To compensate for the loss of salary, it was topped up by reducing their pension deduction. Probably unwise and instead of taking the reduction of lifestyle immediately, in effect it was delayed until retirement.

Theoretically at least, if the Defined Benefit Fund could guarantee 2% per year of employment, surely the Defined Contribution Fund could do at least as well. Herein lay the reason why the employers made it their mission to convert employees to the Defined Contribution method. In reality the Employers often had to bail out the Pension Fund. Especially after GAAP requirements forced companies to disclose the amount of such top-ups, a close reading of Annual Financial Statements revealed the amounts required on an annual basis. After converting, such subventions were no longer possible. In effect the employee would have to invest more privately to cover such shortfalls.

What was not factored into this equation was that with increased life expectancies, it was not possible for one’s savings over 35 years of work to provide for one’s pension requirements lasting for at least 20 years. The correct answer would have been to retire at 70 but this has not happened yet.

More pernicious was the corrosive effect of the fee structure. Like a stealth bomber unseen by even the most financially astute employees, layers of fees were gouged from the returns. The growth in the fund has to cover the following “costs”:

Inflation

Brokers commission

Platform fees

Asset Managers fees and commissions

Instead of utilising the cheapest index tracking funds, expensive actively managed funds were used on the spurious assumption that the additional costs would more than adequately be covered by the additional returns derived. With hidden costs in the equation, most laymen and even brokers were unaware of the true costs syphoned off of this pot of honey.

Would brokers even have suggested index tracking funds if their commission was minimal. How many Brokers offer PPS Life Insurance even though it is the cheapest on the market? The reason is simple: the broker will not earn any commission!

Confounding this argument regarding the true cost of active versus passive management of funds has been been the lack of data in the public domain. Naturally the active managers will fervently claim that they are able to provide their clients with a superior return after their exorbitant commissions.

Anecdotally I dismissed these claims out of hand. My basis was simple. During various contests over the years between fund managers and laymen to ascertain who could derive the greatest return over a period of a year, often the performance of novices would easily outrank that of the professional investment managers. One that readily comes to mind is a contest held by the Sunday Times some 20 to 30 years ago where the top performers were neophytes and not professionals.

Without an alternative, what could one do but invest in these schemes of which there must be 1000s currently.

Then along came Satrix, a low cost method of investing in equities which are the key to any portfolio. This was the first opportunity to bypass all the commission grabbing hands in the investment chain.

An interesting observation is that the use of Active Management appears to be the approach most favoured by Financial Advisers, who would argue that their chosen fund managers are bound to outperform a passive fund. But advisers do not always fully realise how difficult it is to choose the top managers of the future and how many active managers fail to beat the index over the long term. Fortunately data is now available to settle ths argument.

According to performance data provided by Satrix, it shows that consistently choosing the top performing active managers is a daunting task. To choose the average active SA equity manager, for example, it is not sufficient to beat the investable equity index after costs. You would need to choose a top quartile manager. Satrix compared the SA universe of active equity managers’ performance against the SWIX (the best proxy of the investable equity universe) minus 0.57% (the average passive fund fee). As shown in the table below, even over a 10-year period, only slightly more than a quarter of the managers were able to beat the SWIX minus 0.57%.

To bolster this contention, last year only 16.31% of South African equity funds outperformed the S&P South Africa Domestic Shareholders Weighted Index. Over the last five years, that figure falls to just 15.32%.

It is not a great picture for South African active managers, and it gets worse when one compares this to similar ratios around the world:

The three main arguments countering passive investments are:

Passive funds may outperform in bull markets, but active funds do so in bear markets.

The FTSE/JSE SWIX Index is not an appropriate benchmark to measure active asset managers against.

An active asset manager could never hold 12.5% exposure to Naspers as per its current weight in the FTSE/JSE SWIX Index

There are some peripheral arguments, one of which is that index-tracking is immoral and will distort the operations of the markets, but these are really not worth discussing.

Let us compare the statistics for bull and bear markets.

On sober reflection, a bear market on average persists for 18% of the time yet during the bull market being 82% of the time only 32% of active managers beat the market.

Apart from the timelines, it is worth looking at the actual performance.

In a nutshell what this implies is that during the 82% of the time when the market is in a bull phase, index tracking beat active managers by 3.3%. During the bear phase being 18% of time, active managers do beat the index funds but by a paltry 1.8%.

For my money, I wish that I had this information available to me 35 years ago. A howl of protest will probably arise from Active Fund Managers but having seen the pitiful returns that some funds have provided my friends after their investments over decades, greater disclosure of the fee structure will inexorably place downward pressure on fees.

On the old style RAFs, for example, fees at 4% were the norm. Assuming that the inflation rate was 5.5%, the whole of the return would be forfeited to these two components leaving little or no growth. This situation was inequitable

The introduction of RDR – Retail Distribution Review – will have a profound impact upon Fund Managers. The objective of RDR is to reduce the cost of investing in these products. With the customer paying for the platform and for the Advisor, what value proposition will make Asset Managers make to justify their fees?

Previously there was no commission on index funds. As a consequence there was no way for Advisers to be paid if they recommended them. But once that structure changed, index funds have begun to have their day. March this year was illustrative of the future when 85% of net flows went into passive products.

With the consumer now in the driving seat with fewer hidden charges, the Adviser will now be in a position to offer cheaper alternatives without prejudicing their income.

Where does that place me and my fellow retirees or imminent retirees?

Basically we have had the worst of both worlds and now with retirement imminent, what have we left to but sulk and quibble with one’s spouse about the purchase of every item of groceries from the local supermarket. The alternative is to find employment until the age of 70.

Nigel, when one is not working, there is not even the possibility of receiving a handsome incentive bonus which will right the ship. Life is full of nasty surprises. Oddly enough, they are all negative